Key Person Insurance: Protecting the Business Behind the Person

For a lot of small and mid-sized businesses, the most valuable asset isn't the building or the equipment. It's one or two people. If a founder holds the major client relationships, or one salesperson brings in a third of revenue, the business has a concentration risk. Key person insurance is one way to put money where that risk is.

How does key person insurance work?

There are three roles:

• Insured: the key person.
• Owner: the business.
• Beneficiary: the business.

The business applies for coverage with the key person's consent, pays the premiums, and controls the policy. If the insured dies while the policy is in force, the death benefit goes to the business, which can use it however the situation requires.

Who counts as a key person?

Title doesn't decide it. Economic impact does. A key person might be:

• A founder or majority owner
• A partner with essential responsibilities
• A top salesperson or rainmaker
• An executive or technical specialist who would be hard to replace
• Someone who holds major client or vendor relationships
• An owner who personally guarantees business debt

A useful test: what would happen to revenue, debt, and operations over the next 6 to 24 months if this person were suddenly gone? If the honest answer involves lost clients, nervous lenders, or months of recruiting, the exposure is worth measuring.

What can the death benefit pay for?

• Lost revenue or profit while clients and sales recover
• Recruiting and replacement: search fees, signing bonuses, training, transition time
• Business debt, especially loans tied to the owner's involvement
• Working capital to keep payroll and vendors paid during the transition
• Confidence: showing lenders, investors, and employees the business is protected
• Options: time for the remaining owners to decide whether to rebuild, restructure, or sell, rather than being forced into a quick decision

How much key person insurance does a business need?

There's no single formula. A sound number is tied to the actual financial loss, and it has to be financially justifiable to the insurance company, which will ask how the amount was determined.

Common factors include:

• Revenue or profit the person generates
• Cost and time to recruit and train a replacement
• Outstanding business debt and personal guarantees
• Cash reserves already available
• Contracts or clients at risk if the person is gone
• Company value and how much of it depends on this person

Carriers often use rules of thumb, such as a multiple of the person's compensation, as a starting point. Those are a ceiling for underwriting, not a measure of your actual risk. The better approach is to estimate the loss first, then size the coverage.

Should key person coverage be term or permanent?

It depends on how long the risk lasts.

Term insurance often fits when the need has a horizon: a loan with a set payoff date, a growth phase, or a period before a succession plan takes effect. It provides large amounts of coverage at a relatively low cost.

Permanent insurance may fit when the person is likely to stay central to the business indefinitely, or when the policy is part of a longer plan such as succession or buy-sell funding. It costs more and needs ongoing review. See our guide to permanent life insurance.

The need should choose the product, not the other way around.

What must be done before the policy is issued?

This is the step businesses most often miss.

When a business owns life insurance on an employee (including owner-employees), federal tax law under Internal Revenue Code §101(j) generally requires the business to:

1. 1Give the insured written notice that the business intends to insure their life and the maximum face amount,
2. 2Get the insured's written consent to the coverage, including consent that coverage may continue after they leave the company, and
3. 3Do both before the policy is issued.

The business must also meet ongoing reporting requirements, typically IRS Form 8925.

Key person insurance vs. buy-sell insurance

They protect against different losses, even when the same owner is insured.

• Key person insurance protects the business against the economic hit of losing someone.
• Buy-sell funding provides money to buy out the deceased owner's share so ownership passes as planned.

Many businesses with more than one owner need both. They should be analyzed separately so one policy isn't quietly expected to do two jobs. See our guide on funding a buy-sell agreement.

Questions to ask about your business

• Who creates a disproportionate share of our revenue or value?
• How long would it realistically take to replace them?
• Is any debt tied to their personal guarantee or involvement?
• How many months could we operate on current reserves?
• Do we already own key person coverage, and does it still match the business we are today?

If you already have coverage from years ago, a policy review is a good place to start.